How Smart is 'Smart Beta' Investing?

05-06-2014 | Research

Investors increasingly embrace “smart beta” investing, by which we mean passively following an index in which stock weights are not proportional to their market capitalizations, but based on some alternative weighting scheme. Examples include fundamentally-weighted indices and minimum-volatility indices. In this whitepaper we first take a critical look at the pros and cons of smart beta investing in general. After this we successively discuss the most popular types of smart indices that have been introduced in recent years.

David

Blitz

PhD, Executive Director, Head of Quant Selection Research

Recently introduced smart beta indices claim that it is possible to improve upon a traditional capitalization-weighted index by using some alternative weighting formula

The source of the added value of smart beta indices are systematic tilts towards classic factor premiums which are induced by these weighting schemes

Investors should be aware of the pitfalls associated with smart beta indices, which arise because smart indices are not specifically designed for harvesting factor premiums in the most efficient manner, but primarily for simplicity and appeal

Although passive management can be used to replicate smart indices, investors should realize that, without exception, smart indices themselves represent active strategies

Smart beta, essentially an active strategy

We are often asked whether smart beta investing is a form of passive investing. It is important to realize that it is not. Although passive management can be used to replicate smart indices, smart indices themselves are essentially active strategies. The only truly passive investment strategy is the capitalization-weighted broad market portfolio, which represents the only buy-and-hold portfolio that could, in principle, be held in equilibrium by every investor.

Smart beta indices are fundamentally different, because they require various subjective assumptions and choices. Their active nature is also illustrated by the fact that they require periodic rebalancing to maintain their profile.

Smart beta in relation to factor premiums

We think it is important to understand where the added value of smart beta as alternative weighting schemes really comes from. Research has shown that the weighting schemes tend to result in structural tilts towards stocks which score high (or low) on certain factors, and that the premiums which are known to be associated with these factors are driving performance. (Research has shown that the weighting schemes tend to result in structural tilts towards stocks which score high (or low) on certain factors, and that the premiums which are known to be associated with these factors are driving performance. (See for example, Chow, Hsu, Kalesnik & Little 2011, “A Survey of Alternative Equity Index Strategies”, Financial Analysts’ Journal, Vol. 67, No.5, pp 37-57).

For example, compared to the capitalization-weighted index, fundamental indices systematically tilt towards value stocks. These exposures enable the strategy to benefit from the well-known value premium, which, in fact, turns out to fully explain its performance.

But is smart beta investing really smart?

Our view on smart beta investing can be summarized as follows: although smart beta investing may be a good start, we believe that investors can do better. The reason is that the main appeal of smart beta indices, namely their simplicity, is at the same time their biggest weakness. Specifically, we find that the simple tilts towards factor premiums provided by smart beta indices often involve significant risks that are undesirable.

'Although smart beta investing may be a good start, we believe that investors can do better'

In this whitepaper we elaborate on these points by discussing the pros and cons of the most popular types of smart beta indices that have been introduced in recent years.

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